Regulation Best Interest and Customer Dispute Arbitrations: Uncertainty Ahead
As the industry moves past the “good faith effort” and “reasonable progress” standards of the first six months of Regulation Best Interest (Reg BI), the SEC’s standard of conduct for broker-dealers and associated persons when making a recommendation to a retail customer of any securities action or investment strategy involving securities, broker-dealers and associated persons can expect more focused exams and deeper dives into firm practices and documentation by the SEC. In a December 21, 2020 public statement, the SEC’s Division of Examinations announced it intends to “expand the scope of examinations in 2021 that focus on specific requirements of the Regulation, including those that go beyond suitability standards and require broker-dealers to have a reasonable basis to believe that recommendations are in retail customers’ best interests.” While the regulatory scope of Reg BI takes shape, an area of uncertainty remains in how Reg BI will impact customer dispute arbitrations.
Customer Dispute Arbitrations
Litigation of customer disputes typically lags behind regulatory enforcement of the same conduct, with the standard customer dispute arbitration taking approximately twelve to eighteen months to complete (pre-pandemic). This means that arbitrators and the defense bar have yet to see how claimants’ counsel will attempt to utilize Reg BI in statements of claim. One area we anticipate to be incorporated into almost every statement of claim, especially those disputes involving alternative investments, is the obligation of a registered representative to consider reasonably available alternatives. It is safe to assume that every claim involving a non-traded security or relatively illiquid asset will include an allegation of the registered representative’s failure to consider a reasonably available alternative. The SEC states:
What will be a reasonable determination of the scope of alternatives considered will depend on the facts and circumstances, at the time of the recommendation, including both the nature of the retail customer and the retail customer’s investment profile, and the particular associated persons or groups of associated persons that are providing the recommendations.
These claims will likely emphasize the need for broker-dealers and associated persons to present substantial documentary evidence at the final hearing related to the efforts undertaken to analyze reasonably available alternatives. In the past, an associated person may have been able to put forth persuasive hearing testimony regarding the potential risks, rewards, and costs associated with a recommendation, how that recommendation fit the specific investor profile of a customer, or the consideration of reasonably available alternatives. As claims involving recommendations made under the new Reg BI standards rather than FINRA’s old Rule 2111 suitability standard, it is likely that documentation of recommendations generated contemporaneously will be necessary to defend claims.
As these claims are asserted more frequently by customers, FINRA may amend the Discovery Guide and document production lists. While the production of the majority of this documentation is likely covered under Rule 12506, changes to the Discovery Guide and document production List 1 may be made to specifically require broker dealers and associate persons to produce documents related to costs, reasonably available alternative investments, and conflicts of interest.
As an example, List 1 – item 3 requires the production of “[a]ll documents evidencing any investment or trading strategies utilized or recommended in the customer parties’ accounts, including, but not limited to, options programs, and any supervisory review of such strategies.” While this item requires the production of documents related to the specific strategy employed, it arguably does not require the production of any alternative strategies considered. No other list item appears to require the production of documentation evidencing the consideration of reasonably available alternatives.
At the moment, it is unclear how claimants’ counsel will utilize the Regulation in the prosecution of customer disputes. What is clear, is that the extent to which broker-dealers and associated persons implemented processes to comply with Reg BI may directly impact their ability to defend future customer disputes.